Ronald Phillip Ellison Jr. has been investing in real estate since he was a teenager. Back in 1988, the U.S. Department of Housing and Urban Development had a lot of properties for sale in the Detroit area. “My father helped me buy one for $3,000,” says Ellison, 34, who currently lives in Bloomfield, Michigan. “The rental income helped me pay for college, and I eventually sold the house for a profit of more than $15,000, including the money I put in it to fix it up.”
Ellison, a medical products salesman, continues to hold investment real estate today. He and business partner Timothy Hoke have formed a limited liability company and currently own 15 single-family homes, duplexes, and multifamily buildings. Ellison and others who have successfully acquired investment properties all had detailed home-buying strategies with clearly defined goals and objectives.
Real estate can be a great investment, but not every property is a big winner. To make money, short- or long-term, it’s important to buy the right property at a reasonable price. This may sound simple, but the details can be complicated. Here are some guidelines to follow:
SET GOALS. “When you seek rental property, you should know whether your primary objective will be current cash flow or long-term appreciation,” says Jocelyn Wright, a financial planner with Wealth Development Strategies in Houston. She explains that if your goal is cash flow, you’ll need to figure out how much you think you’re going to spend on repairs and whether you’ll have to borrow that money. “The more money you have to borrow to buy the property and make improvements, the higher your mortgage will be,” says Wright. And that will cut into your profits.
You may also want to focus on real estate that you can rent to low- to moderate-income tenants. “Properties in the inner-city may not appreciate as much as property in more desirable locations,” says Marilyn Broussard, a Waddell & Reed certified financial planner in St. Paul, Minnesota. Such properties are more likely to deliver income than long-term gain through appreciation.
Indeed, the most cash flow will come from low-income properties, according to Bob Bruss, a real estate attorney and syndicated columnist in Burlingame, California. “You’ll probably have more intensive management responsibilities there — along with generating current income,” he says. “In better neighborhoods, you’ll pay higher prices for property in relation to rents. Thus, you’re more likely to have negative cash flow … but you may have more potential for appreciation.”
Bruss provides a rule of thumb for property investors. “You should anticipate receiving 1% of a property’s purchase price in monthly rent if you want to cover expenses,” he says. “For example, if you pay $100,000 for a property, you may need $1,000 in monthly rent to avoid negative cash flow. If a property is likely to generate negative cash flow, it should offer upside appreciation potential in order to make investing worthwhile.”
Some investments are better suited to provide income rather than appreciation growth. “I once owned Section 8 property,” says Jeff Boyd, 40, of Woodbury, Minnesota, referring to a unit where rents are government subsidized. “Some people like Section 8 investments because your rental income is guaranteed,” he explains. “[But Section 8 tenants] might be less apt to take care of the property, which can lead to more wear and tear.” Boyd says that many Section 8 tenants don’t work and are home during the day, which increases wear and tear on the property.
The unit Boyd rented out to Section 8 tenants was in such disrepair, he had to do extensive cleanup and restoration before he could rent the unit again. “Based on my experience, I would avoid Section 8 properties in the future.”
For some, current cash flow may be secondary to price appreciation. “If you have long-term goals,” says Wright, “one option is to buy land without a structure on the property. If you buy property in the path of development, you may be able to sell at a profit in the future, perhaps when you’re ready to retire and need more income.” Determining the direction of future development is not easy, but local real estate professionals might be able to help you track current trends.
Boyd says that if you want rapid appreciation, your best bet is to buy a property that needs work: “Put in $10,000 to $15,000 worth of improvements and you may well be able to resell it immediately at a substantial profit.”
Broussard cautions that holding a property for either type of investment gain — current cash flow or appreciation — carries risk. “From a financial planning standpoint, it’s important to have the ability to handle any negative cash flow that might result,” says Broussard. “You might have months of vacancies. If so, you won’t be in a good situation without a cash cushion.” Therefore, you should make sure you have enough cash to handle the maintenance needs of the property as well as the usual expenses such as mortgage interest, taxes, and insurance.
KNOW THE NEIGHBORHOOD. Whether you’re looking for current cash flow or long-term appreciation, “You have to consider the neighborhood,” says Ellison. “Picking the best investment properties in Detroit, which has some blighted areas, can be much different from buying in the suburbs, where you can find some of the nicest communities in the country.”
“In the city,” he continues, “we look for the worst house on the block. We say, ‘If we can make it livable, will people want to own it?'”
Ellison says that you should not be put off by city properties that are not in the best shape. “It’s a matter of affordability,” he explains. “You say to yourself, ‘If I had a modest income and could afford to pay only so much for a house, is this where I’d want to live?'”
Deciding if tenants would want to live in the neighborhood wasn’t an issue for Monté Ross, 34, an assistant basketball coach at St. Joseph’s University in Philadelphia. His first investment property was on the same north Philadelphia block he grew up on. “My grandfather kept a finger on the pulse of the neighborhood,” he says. “He found out that an older woman wanted to get rid of the three-story, single-family house she owned.” Ross bought the house for a nominal sum, understanding that it would need renovation.
“My father is a contractor,” says Monté’s wife Michelle, 35, an elementary school teacher. “He helped us convert the home into a triplex that we could rent out.” They still own the property, which has appreciated substantially as well as generated positive cash flow.
For the Rosses, owning a property near downtown Philadelphia, better known as Center City, has paid off. “It has become a much more desirable area,” says Michelle. “People like the convenient location and the ability to find parking on the street. In addition, our area gets more frequent garbage pickup than other areas because it’s near Center City.”
Boyd, who owns and operates his own Web business, also began investing in real estate in an area he didn’t mind living in. “When I was out of college,” he says, “I went looking for a duplex. I needed a place to live and I wanted a tenant in the other unit so [their] rent could help pay the mortgage.”
It took him more than six months to find the right place, but it was worth the search. “I still own it 15 years later, [and now] both units are rented,” says Boyd. “It has been a fantastic investment. Besides the rental income all these years, the house — which I bought for $60,000 — is now worth around $240,000.”
The property Boyd finally settled on was
a few miles from the University of Minnesota in Minneapolis. “It’s a blue-collar, low- to middle-income neighborhood with older homes,” he says. “It’s a quiet area, near churches, parks, and schools. I was willing to live there myself, so I figured I would be able to get responsible tenants.” He says investors should look at the area within a five- to 10-mile radius of the property they’re considering to see if new development is under way: “If stores such as Home Depot are going up, that will help property values.”
Of course, not all good investment property will be found within city limits. “In the suburbs, there are fewer neighborhoods where you won’t want to buy,” says Ellison. “We look for a house that hasn’t been taken care of — often because something is going on, such as a death in the family or a financial reversal. We’ve had success tracking down owners of such properties from public records, buying the houses, and putting them back in good condition.”
Whether you’re investing in a city, suburb, or rural area, you should check out the surrounding area. “See for yourself if the neighborhood is being maintained or getting run down,” says Diane St. James, a mortgage counselor and underwriter in Allentown, Pennsylvania. “If there are houses on the street that are boarded up, you may want to p
ass. The same is true if you see a lot of nearby homes for sale. In such neighborhoods, it may be difficult to get a tenant [who pays consistently], even if you do get a property at a low price.”INVESTIGATE CAREFULLY BEFORE BUYING. Look closely at any property before buying. “Use the same criteria as you would when buying a house for your own residence. Have an inspector determine whether the building is structurally sound,” says Damon Dyas, a certified financial planner with American Express Financial Advisors in Southfield, Michigan. You also need to find out if the underlying grounds have any environmental liabilities.
“Be prepared for problems,” says Ellison. “Even if you inspect the property, you may eventually face issues with plumbing, electricity, or the furnace.” You should have enough capital to handle repairs so you can keep the house rented and perhaps resell at a profit in the future. Bruss says that some problems, such as peeling paint, can be corrected, but others may be permanent. “Be wary of incurable defects. If a house gets a lot of noise because it’s on a busy street, you can’t do much about it.”
PRICE IT RIGHT. Once your property is ready to be shown to prospective tenants, be sure to charge an appropriate amount of rent. “This may be an especially important issue if you move out of a house where you’ve been living and decide to rent to a relative rather than sell it,” says Dyas.
“I’ve seen instances where the property owner’s relative is not paying the fair market value. In some cases, the relative misses rent payments. Either way, they’re taking advantage of the investor,” says Dyas. “You should know what properties are renting for in your area and make sure that all of your tenants are regularly paying an appropriate amount.”
PARLAY YOUR WINNERS. The only thing better than owning a profitable piece of investment property is owning several. That’s been the philosophy of the Rosses, who now own four rental properties. “We bought our second investment property before we owned a home for ourselves,” says Michelle.
Their first property, the triplex on Monté’s old block in Philadelphia, was bought for such a low price it had no mortgage. “As it gained value, we were able to borrow against it,” says Monté. “We used that money to make down payments on two more similar properties.” Monté picks the family’s real estate investments while Michelle handles record keeping and maintenance.
“Two of our properties are in the same neighborhood as our first one,” says Monté. “We know the surroundings, and we have a certain comfort level there. When you’re buying property to rent to other people, the first thing to check is whether you’re comfortable there. If so, your tenants will feel comfortable as well.” And having rental properties in the same area makes it easier for the Rosses to manage them.
Three of the Rosses’ properties have benefited from their close proximity to Temple University. “There’s always a demand for housing from college students and faculty. In fact, Monté is now looking for properties near Penn and Drexel [universities],” she adds. The Rosses have recently begun searching for tenants for their fourth property, which is near St. Joseph’s University.
Doing your homework and prudently handling the proceeds from rental property can help make your real estate investments a happy ending to your life’s story.